1.3.4 price mechanism

What is the price mechanism?

The process by which market prices are determined through supply and demand

Who described the price mechanism as the “invisible hand”?

Adam Smith

How are resources allocated in a free market economy?

Through the price mechanism

How does the price mechanism solve the problem of scarcity?

By moving resources to where they are demanded and away from where there is surplus

What are the three main functions of the price mechanism?

Rationing, incentive, and signalling

What is rationing?

Using price increases to reduce demand and allocate scarce resources

Why does rationing occur?

Because excess demand pushes prices up

Example of rationing

Plane ticket prices rising as seats become scarce

What is incentive?

Using price to encourage a change in behaviour by consumers or producers

How does price act as an incentive to firms?

High prices encourage firms to supply more because it is more profitable

What is signalling?

Prices providing information about where resources are needed

How does a high price act as a signal to firms?

It encourages new firms to enter the market

How does a high price affect consumers?

It discourages demand and causes some consumers to leave the market

How does signalling affect supply and demand curves?

It causes shifts in demand and supply

What is a mass market?

A large group of consumers for a product

Example of a mass market

Restaurants

What is a niche market?

A smaller market focused on a specific product or consumer group

Example of a niche market

A restaurant specialising in Italian cuisine

Why is the price mechanism effective in mass and niche markets?

It allocates resources to where they are most wanted

Why may niche markets allocate resources more efficiently?

They are closer to consumers and target specific preferences

Why might niche markets be more profitable?

Consumers are directly targeted, reducing waste and improving efficiency